There's another reason why it might be a good idea to break up the banks: the smaller the bank, the better it is at writing mortgages. At least, that's what the data shows. This point was made Tuesday morning at a Senate Banking Committee hearing on ensuring that small institutions remain competitive in the mortgage industry. The evidence is pretty compelling.

Here's a chart, created by one of the hearing's witnesses, Edward J. Pinto, resident fellow at the American Enterprise Institute and former chief credit officer at Fannie Mae:

mortgage performance by size 2011-q1.png

A number of reasons could explain this relationship

First, big banks focused more on volume than quality. When you're trying to originate more loans than your competitor, it's easy to let standards fall.

Second, smaller community banks know their customers better than big banks who might view their customers as more of a number. So first, smaller banks have a better idea which of their customers are good bets for mortgages. But having stronger relationship with your customers also helps ensure that those mortgages continue to perform through servicing. Smaller banks are more likely to have the will and patience to work with a struggling customer to bring a loan current again.

Third, bigger banks often were more focused on originating mortgages to subprime borrowers as stipulations made as part of merger conditions over the past decade or two. While some of these loans might have been able to be sold off to Fannie and Freddie or securitized, those that didn't make the cut -- which might have been the very worst -- remained in their portfolio.

Finally, due to their more aggressive efforts to distribute mortgage risk through Fannie/Freddie and securitization, larger banks likely had more loans get kicked back. The big originators probably paid less attention to loan quality if they believed the mortgages could be sold off. When they were rejected by buyers, however, they had to take them back. Many of them went bad.

You might notice that all of these reasons have something in common: they involve chasing volume instead of concentrating on sound underwriting. This is a problem when banks try to get bigger and bigger and begin to ignore the risks that they take along the way. During a bubble period, the temptation to pursue volume becomes even stronger.

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